How Can Commodity Producers Reduce Procyclicality? Jeffrey Frankel

1. How Can Commodity Producers Reduce Procyclicality?Jeffrey Frankel For G-20: Completing the Agenda, AEEF Conference.Session on Fighting Volatility in Commodity Markets, French Ministry of Finance, Paris, 11 Jan. 2011

2. Part I: The Natural Resource CursePart II: An Idea for Making Fiscal Policy Less ProcyclicalPart III: An Idea for Making Monetary Policy Less ProcyclicalAddendum: An Idea for Making Rice & Wheat Policy Less Procyclical

3. Part I: The Famous Natural Resource Curse • Economic performance among those with oil, mineral or agricultural resources • tends to be no better than among those without, • and often worse. JF, 2010c,“The Natural Resource Curse: A Survey,”NBER WP No. 15836. Forthcoming, Export Perils, edited by Brenda Shaffer (Univ. Penn. Press).

4. Economic growth among mineral-exporting countries is, if anything, lower than others.

5. Seven possible channels of NRC • Procyclical fiscal & monetary policy • Crowding out of manufacturing • Matsuyama (1992). • High volatility of commodity prices • Hausmann & Rigobon(2003), Poelhekke & vanderPloeg (2007), Blattman, Hwang & Williamson (2007). • Poor institutions • Auty (1990, 2001, 07, 09), Engerman & Sokoloff (1997, 2000, 02), Gylfason (2000, 2010),Sala-I-Martin&Subramanian(2003), Isham, Pritchett,etal(2005),Bulte,Damania&Deacon (2005),Mehlum,Moene&Torvik(2006), Arezki&VanderPloeg(2007), Arezki&Brückner(2009). • Others: • Allegedly downward long-run trend of commodity prices • Prebisch(1950) -Singer(1950) hypothesis. • Unsustainable natural resources, especially with unenforceable property rights • Findlay & Lundahl(1994, 2001),Barbier(2005a, b, 2007),Robinson, Torvik & Verdier(2006). • Civil war • Fearon & Laitin (2003), Collier & Hoeffler (2004), Humphreys (2005) and Collier (2007).

6. Revisionists point out • resourceexports are endogenous • many exceptions to the NR Curse. • Regardless, the relevant question is what should a resource country do, • to avoid NRC pitfalls & maximize performance: • to achieve the performance of a Chile, rather than a Bolivia • a Botswana, rather than a Zambia. • An important part of the answer is to avoid procyclical (destabilizing) macro policies • which are expansionary in booms • exacerbating debt, overheating, inflation & bubbles, • and contractionary in busts.

7. Institutions • “Institutions” have become a development mantra. • E.g., it is not enough for the IMF to tell countries to run budget surpluses during expansions; the country must: • “take ownership,” • develop institutions to deliver the desired macro policy in the real world of political pressures & human frailties. • But expert advice is often frustratingly non-specific regarding what institutions, exactly, developing countries should adopt.

8. Two very specific proposals for countercyclical institutions,one for fiscal policy and one for monetary • Fiscal policy: emulate Chile’s budget institutions. • Monetary policy: Product Price Targetinginstead of targeting the CPI or exchange rate. PPT

9. Part II: Fiscal policy • Among most developing countries, government spending has been procyclical: • rising exuberantly in booms • and then forced to cut back in busts, • thereby exacerbating the cycle • Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Mendoza & Oviedo (2006), Alesina, Campante & Tabellini(2008), and Ilzetski & Vegh (2008). • Particularly among commodity-producers • Gelb (1986), Cuddington (1989),Medas & Zakharova (2009). • Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003), • Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010). JF, 2010d, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” Fiscal Policy & Macroeconomic Performance, 14th Annual Conference of the Central Bank of Chile,Oct.21-22, 2010, Santiago.

10. Correlations between Gov.t Spending & GDP G has long been pro-cyclical for most developing countries. } Source: Kaminsky, Reinhart & Vegh (2004) Data from 1960-2003. procyclical countercyclical

11. A decade of Chilean fiscal policy • In 2000 Chile instituted its structural budget rule. • The institution was formalized in law in 2006. • The government sets a target for the structural budget, • originally BS > 1% of GDP, then cut to ½ %, then 0 -- • where structural is defined by output & copper price equal to their long-run trend values. • In a boom the government can only spend increased revenues that are deemed permanent; any temporary copper bonanzas must be saved.

12. In 2008, with copper prices spiking up, the government of President Bachelet wasunder intense pressure to spend the copper revenue. • She & Finance Minister Velasco held to the rule, saving most of it. • This made them unpopular with groups who wanted to spend. • When the recession hit and the copper price came back down, the government increased spending, mitigating the downturn. • Bachelet & Velasco became heroes.

13. Budget rules alonedon’t prevent deficits in booms • as Europe’s SGP demonstrates. • (1) Need structural budget targets • to allow surpluses in booms & deficits in busts. • (2) Econometric findingsamong 33 countries(Frankel, 2010): • Official budget forecasts are • overly optimistic on average, • especially during booms, • especially at 3-year horizons, • especially among countries with budget rules (SGP). • => In most countries, the political process “achieves targets” by optimistic forecasts, not by actual policies.

14. The crucial institutional innovation in Chile • How has Chile avoided over-optimistic forecasts? • especially the historic pattern of over-exuberance in commodity booms? • The official estimation of the long-term path for GDP & the copper price is madeby two panels of independent experts, • and thus avoids wishful thinking. • Others might usefully emulate Chile’s innovation • or in other ways insulate budget forecasts from politics.

15. Part III: Monetary policy Commodity-exporting countries • experience large trade fluctuations, • cannot depend on the countercyclical capital flows of the finance textbooks, • and need a strong nominal anchor for expectations.What should be their nominal anchor? JF, 2010a,“A Comparison of Monetary Anchor Options for Commodity-Exporters, Including Product Price Targeting, in Latin America,” NBER WP No. 16362.

16. My proposal: Product Price Targeting: PPT • target an index of product prices • rather than the CPI, • so that export commodities get a big weight • and import commodities do not. • My claim: for countries vulnerable to terms-of-trade shocks, it delivers more stability than an exchange rate target, CPI target, or other standard nominal anchors.

17. Why is PPT better than a fixed exchange ratefor countries with volatile export prices? Better response to trade shocks: If the $ price of the export commodity goes up, the currency automatically appreciates, moderating the boom. If the $ price of the export commodity goes down, the currency automatically depreciates, moderating the downturn & improving the balance of payments. PPT

18. Why is PPT better than CPI-targetingfor countries with volatile terms of trade? Better response to trade shocks: If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate the currency. Wrong response.(E.g., oil-importers in 2007-08.) PPT does not have this flaw . If the $ price of the export commodity goes up, PPT says to tighten money enough to appreciate. Right response.(E.g., Gulf currencies in 2007-08.) CPI targeting does not have this advantage. PPT

19. Since Brazil, Chile, Colombia & others switched from exchange rate targets to CPI targets, they have experienced a higher correlation between the $price of their currencies and the $price of oil imports. • => Talk of core CPI notwithstanding, the monetary authorities in the IT countries respond to oil import price increases by contracting enough to appreciate their currencies, • = procyclical monetary policy, • the opposite of accommodating an adverse trade shock. • PPT would not have this problem. IT

20. LAC Countries’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with $ Import Price Changes Table 1 IT IT coun-tries show correl-ations > 0.

21. Summary recommendations to make monetary policy less procyclical • If the status quo is a basket peg, consider putting some weight on the export commodity • to allow appreciation in commodity booms • and depreciation in busts. • If the status quo is Inflation Targeting, consider PPT: replacing the CPI with a product price index, • to allow appreciation in commodity booms • and to prevent appreciation when import prices rise.

22. Addendum: Proposal to make rice and wheat policy less procyclical • Many policies adopted in the name of reducing commodity price volatility have been in effective at best, or counterproductive at worst. • Examples: • Commodity marketing boards • Banning short sales in futures markets • Recent policies in the name of food security

23. Attempts to cap domestic prices of rice or wheat backfire • Among grain producers, • some governments have used export controls • to try to insulate consumers from rises in the world price. • Examples: Argentina’s wheat & India’s rice in 2008 and Russia’s wheat in 2010. • Among grain importers, • the commodity is rationed to domestic households • or else the excess demand at the below-market domestic price is made up by imports. • Capped exports from the exporting countries and price controls in the importing countries both work to exacerbate the magnitude of the upswing of the price for the (artificially reduced) quantity that is still internationally traded.

24. Proposed cooperative solution • If the producing and consuming countries in the rice market could cooperatively agree to refrain from government intervention in crises, price volatility would be lower, rather than higher, • even though intervention is motivated in the name of supposedly reducing price volatility. • International trade in rice or wheat can be a valuable buffer, if it is allowed to operate.

26. Elaborations on Macro Policy Proposals: I. Chile’s Structural Budget Innovations: Institutions for Commodity Producers to Achieve Countercyclical Fiscal Policy II. PPT: Proposal for Commodity Producers to Achieve Countercyclical Monetary Policy

27. Terms of trade volatility is particularly severe for commodity exporters • Oil & natural gas are the most variable. • But the prices of aluminum, coffee, copper, & sugar all show standard deviations > .4; => price swings of + or - 80% occur 5% of the time.

28. I. Chile’s institutional innovations to achieve countercyclical fiscal policy • Chile’s accomplishment • Budget rules • Econometric findings regarding official forecasts • of budget balances • of GDP growth rates.

29. The historic role reversal • Over the last decade a few emerging market countries finally achieved countercyclical fiscal policies: • They took advantage of the boom years 2003-2008 • to run primary budgetsurpluses. • Debt levels among top-20 rich countries(debt/GDP ratios ≈ 80%) are now twice those of the top-20 emerging markets. • Some emerging markets have earned credit ratingshigher than some so-called advanced countries. • They thus were able to respond to the global recession by easing fiscal policy, • with the result that they recovered more quickly than others.

30. Public approval ratings for Chile’s President Bacheletwas very low in 2008. Source: Engel, Nielsen & Valdes (2009)

31. In 2009, approval ratings of Pres. Bachelet shot up to the highest levels since the restoration of democracy in Chile,despite the recession that had hit. Why? Source: Engel, Nielsen & Valdes (2009)

33. Correlations between Gov.t Spending & GDP Updating to 2009: Chile has managed to achieve countercyclical fiscal policy. procyclical Source: Vegh countercyclical

34. The Pay-off • Chile’s fiscal position strengthened immediately: • Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005 • allowing national saving to rise from 21 % to 24 %. • Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. • By 2006, Chile achieved a sovereign debt rating of A, • several notches ahead of Latin American peers. • By 2007 it had become a net creditor. • By 2010, Chile’s sovereign rating had climbed to A+, • ahead even of some advanced countries. • => It was able to respond to the 2008-09 recession & 2010 earthquake via fiscal expansion.

35. Institutions that are often proposedto put aside wealth from export earnings: • Sovereign Wealth Funds • But there is no reason to expect SWF governance necessarily to be better than the rest of the budget. • Budget rules • E.g., deficit < 3% of GDP. (Euroland’s SGP.) • But such rules lack credibility • because the limits tend to be violated, • in part because they are too rigid.

36. The design of budget rules • The SGP is too rigid to allow the need for deficits in recessions, counterbalanced by surpluses in good times. • “Tougher” constraints on fiscal policy do not always increase effective budget discipline -- • countries often violate the rules -- • especially when a budget target that might have been reasonable ex ante becomes unreasonable after an unexpected shock, • such as a severe fall in export prices or national output. • In an extreme set-up, a rule that is too rigid, so that official claims that it will be sustained are not credible, might even lead to looser fiscal outcomes • than if a more flexible rule had been specified at the outset. • Neut & Velasco (2003): theory.Villafuerte, et al (2010): in Latin America

37. The design of budget rules,continued • Obvious solution: specify budget targets in structural terms – conditional on GDP & other macroeconomic determinants. • But: Identifying what is structural vs. what is cyclical • is hard • and is prone to wishful thinking. • Thus specifying the budget rule in structural terms does not solve the problem, if politicians are the ones who judge what is structural.

38. 5 econometric findings regarding bias toward optimism in official budget forecasts. • Official forecasts in a sample of 33 countries on average are overly optimistic, for: • (1) budgets & • (2) GDP . • The bias toward optimism is: • (3) stronger the longer the forecast horizon; • (4) greater for eurogovernments underSGPbudgetrules; • (5) greater in booms.

39. The optimism in official budget forecasts is stronger at the 3-year horizon, stronger amongcountries with budget rules, & stronger in booms. Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

40. 5 more econometric findings regarding bias toward optimism in official budget forecasts. • (6) The key macroeconomic input for budget forecasting in most countries: GDP. In Chile: the copper price. • (7) Real copper prices revert to trend in the long run. • But this is not always readily perceived: • (8) 30 years of data are not enough to reject a random walk statistically;200 years of data are needed. • (9) Uncertainty(option-implied volatility)is higher when copper prices are toward the top of the cycle. • (10) Chile’s official forecasts are not overly optimistic.It has apparently avoided the problem of forecasts that unrealistically extrapolate in boom times.

41. Copper price movements dominate budget forecasting in Chile in the short term Figure 7b Frankel, 2010, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

42. Forecasts do internalize the tendency for copper prices to revert toward long-run equilibrium Figure 4: Copper prices spot, forward, & forecast2001-2010 Frankel, 2010, “A Solution to Fiscal Procyclicality….” forward price

43. In sum, institutions recommended to make fiscal policy less procyclical: • Set a target for cyclically-adjusted budget balance • perhaps a surplus, • if you need to amortize a depletable resource, or past debt, • and if you can’t depend on aid to finance a deficit. • Follow Chile: • Define cyclical adjustment in terms of • GDP relative to long-term trend and • the price of the export commodity relative to long-term trend. • Trend should be calculated by • an independent panel of experts, or a simple 10-year average; • rather than by officials subject to political temptation.

44. II. Elaboration on PPT: The proposal for commodity-exporters to achieve countercyclical monetary policy • The need for alternatives to CPI-targeting • Alternative commodity export price measures • Does PPT give the same answer as floating? • Some empirical results • for Latin American commodity-exporters.

45. 6 proposed nominal targets and the Achilles heel of each: Vulnerability IT Professor Jeffrey Frankel

46. What should be the nominal anchor for monetary policy? Fashions change: • 1980-82: Monetarism(target the money supply) • 1984-1997: Exchange rate targets (for developing countries) • 1999-2008: Inflation Targeting --IT has been the new conventional wisdom • among academic economists • at the IMF • among central bankers. IT

47. IT What is the definition of IT? • It is hard to argue with IT when defined broadly: “choose a long run goal for inflation & be transparent.” • But something more specific is implied. • The narrow definition of IT would have central bank governors commit each year to a goal for the CPI, and then put 100% weight on achieving that objective to the exclusion of others. • The price target is virtually always the CPI (though sometimes “core” rather than “headline” CPI). • I propose other price indices, possible alternatives to the CPI for the role of nominal anchor.

48. We are not talking about rules vs. discretion,or how flexible to be. • Some IT proponents say “flexible inflation targeting”: the central bank puts some weight on the output objective rather than all on the inflation objective • at the 1-year horizon, • as in a Taylor Rule. • The focus here is not on the eternal question how much weight to place in the short term on a nominal anchor • vs. the real economy, • but rather: whatever weight is to be placed on a nominal anchor, what should be that nominal anchor?

49. My view:The standard options are not well-suited to a country exposed to high terms of trade volatility • I propose a set of nominal anchors that could be described as inflation targeting – • but targeting a product-oriented price index in place of a Consumption Price Index.

50. The Product Price Alternatives • PegtheExportPrice: In the pure form, fix the price of domestic currency to the leading export commodity. • PEP-basket: Set the price of domestic currency in terms of a basket of currencies & the export commodity. • PegtheExportPrice Index: peg to an index of prices of major export commodities • Product Price Targeting: target a comprehensive index of domestically produced goods. They all have in common: substantial weight on the export commodity, not on the import commodity –whereas the CPI does it the other way around. PEPI PPT